In 2005 the Keenan Company paid dividends totaling $3,600,000 on net income of $10.8 million. Note that 2005 was a normal year, and for the past 10 years, earnings have grown at a constant rate of 10 percent. However, in 2006, earnings are expected to jump to $14.4 million, and the firm expects to have profitable investment opportunities of $8.4 million. It is predicted that Keenan will not be able to maintain the 2006 level of earnings growth—the high 2006 earnings level is attributable to an exceptionally profitable new-product line introduced that year—and the company will return to its previous 10 percent growth rate. Keenan’s target capital structure is 40 percent debt and 60 percent equity. 

a. Calculate Keenan’s total dividends for 2006 if it follows each of the following policies:

(1) Its 2006 dividend payment is set to force dividends to grow at the long-run growth rate in earnings.

(2) It continues the 2005 dividend payout ratio. 

(3) It uses a pure residual dividend policy (40 percent of the $8.4 million investment is financed with debt and 60 percent with common equity). 

(4) It employs a regular-dividend-plus-extras policy, with the regular dividend being based on the long-run growth rate and the extra dividend being set according to the residual policy.

b. Which of the preceding policies would you recommend? Restrict your choices to the ones listed, but justify your answer.

c. Assume that investors expect Keenan to pay total dividends of $9,000,000 in 2006 and to have the dividend grow at 10 percent after 2006. The stock’s total market value is $180 million. What is the company’s cost of equity?

d. What is Keenan’s long-run average return on equity?

e. Does a 2006 dividend of $9,000,000 seem reasonable in view of your answers to parts c and d? If not, should the dividend be higher or lower?